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Elect to be public.
Benefits of going public: capital is easier than getting private investors, liquidity increases if
shares can be sold on market, risk shifting/cashing out, prestige, reputation, credibility.
Costs of going public: offering cost (7% underwriter commission, legal, printing), time of
management, liability possibility, diminishes control unless you make separate classes of stock,
efficiency issues (usually sell for less than it is really worth).
Factors for whether you should go public:
Companys Size$20MM in annual sales and $1MM net income in current year
Financial Ratios and Historic Performancedebt-equity ratio, liquidity, debt coverage
should all be in line with industry average; need 12 to 15% growth per year.
Current Managementhigh-quality executives with broad experience.
Public Appeal of Businessgrowing industry, be an industry leader or have a niche.
Market Conditions
Steps of an IPO on page 32 of the book.
What is a Security?
Anything can be a security if its an investment where you expect to earn profits on labor of others.
SEV v. W.J. Howey Co. shows how oranges can be a security.
Investors bought land on orange farm.
With the land investors purchased service contract in which Howey would take care of
the land and distribute profits to the investorsdeemed to be security in orange field.
Definitions
The syndicate then sells the securities to the public and makes a profit or loss based on
its percentage of the block. The head underwriter gets a fee from the proceeds.
Best EffortsUW sells the most that it can (less risk to UW)
Standbycorp. offers securities to existing SH, those that arent purchased are bought
by UW. Variation of firm commitment.
Broad use of issuer in the definition to include control persons
Dealer (2(a)(12))
Distinction between dealer and broker: in the industry, despite what Securities Act says, a
dealer trades for his own account and takes title before selling while a broker serves as an
intermediary and never takes title to the stock.
Emerging Growth Company (2(a)(19))Company with revenue of less than $1B
Allowed to file confidential registration statements so no one will know if you change
something or withdraw.
Must make all material information available to the public when you are making a public
offering of securities.
33 Act has mandatory disclosure requirements, forms of disclosure, and prohibitions on
other disclosures.
First a company must file a registration statement, and then once it is made effective by the
SEC, they can sell securities.
General information required by registration statement
Description of properties and business
Description of security to be offered for sale
Info about management of company
Financial statements certified by independent accountants.
3 PeriodsSecurities Act 5 (CHART ON PG 79)
Pre-filing Period 5(a),(c)no offers or sales of securities before registration statement
filed.
Non-reporting Issuer
Allowed
Preliminary negotiations and agreements with underwriters
Exception put in 2(a)(3) to offers and sales for the purposes of 5(c)
Rule 135 Communications
Allows purely informational statements explaining an offer is taking place.
Only allows for when and where it is happening, manner and purpose.
No substantive information is allowed, not even name of UW.
Legend: statement that it does not constitute an offer of securities for sale
Rule 163A Communications
Communications that dont mention the offering, but might condition the
market in some waycan wait 30 days and fit in this safe harbor.
If your statement mentions the offering, there is no bright-line rule and
you dont know how long you have to wait. May never be able to make
the offering.
Still must take reasonable steps to stop further dissemination of
statements.
Doesnt apply to certain communications under 163A(b)
Rule 169 Communications
Regularly released factual information in the ordinary course of business
will not violate 5(c)
Major question here is if youve released similar statements in the past.
Shelf Offeringallows company to have a registration statement waiting for when they want
to offer again. Faster alternative.
Rule 415 controls shelf offerings
Limited to certain offerings. 415(a)(1).
If not an S-3 issuer (non-registered issuer) then there is a 2 year limit.
S-3 Filer must be:
Public Reporting Company
Have been one for at least 12 months
More or less a seasoned issuer.
Rule 430B allows a base prospectus to leave out info and include it in a later
supplement when you are ready for a shelf takedown
Process
File S-3 with SEC as a base prospectus
May go through notice and comment in SEC
Declared Effective
Wait until market looks good for selling the securities
File a 424(b) pricing amendment then you sell.
Automatic Shelf Offeringno need to wait for the registration statement to be effective. As
soon as the company files the base statement it is effective.
Defined in Rule 405
462 says it is effective upon filingno waiting period
Unless SEC notifies of an objection, RS will be deemed on the right form.
430B(a) says you only need to specify a class of securities, not amount/price
What must be Disclosed? Reg C (400s) gives mechanics.
Rule 408 requires all material information necessary to make the statement not misleading.
Materiality and Valuation must be disclosed
Materiality is determined by Efficient Capital Market Hypothesis (ECMH)
The price of a stock is the public valuation of all information
That means if price changes, the information was important to investors.
Materiality means anything that a reasonably prudent investor would care about, so
a change in price means the information was material.
Supreme Court adopts ECMH in Basic v. Levinson
Valuation is determined by discounted cash flows
(amount in year one)/(1+discount rate)^years from now
Also called Fundamental Analysis.
There are many explicit prescriptions
Forms (S-1 and S-3)
S-1 is for non-reporting issuers because they just cant use anything else.
S-3 is for seasoned issuers. Allows more reference to other forms that they have
disclosed on.
Public Companies for at least one year and timely filed your reports.
F-1 is an S-1 for foreign companies
S-4 is used for M&A transactions
Reg S-K incorporates corporate information.
Reg S-X incorporates a lot of accounting materials. GAAP standards.
SEC can determine more disclosure is necessary after review and comments.
There can be liability for material omissions in disclosure.
Forward Looking Disclosures
Formerly frowned upon by SEC, but now they are being more encouraged because it is
what investors want.
Registration Exemptions
Private Placement4(a)(2)
4(a)(2) exempts transactions by an issuer, not involving any public offerings
What is a public offering?
Ralston Purina says that there isnt a limit on the number of people, they just have to be
informed.
Public does not mean open to the whole world.
Limiting the offer to key employees is not a good enough limitation because
employees are just as uninformed as general public.
More sophistication in the limited classless disclosure required.
Release 4552
Who the offerees are matters, not just who the purchasers are.
Securities must come to rest with the purchaser. If purchaser acquires the
securities with a view to public distribution, seller assumes risk of possible violation
of the registration requirements.
Not strict liability for the issuer here.
Look to see what issuer did/could have done to stop this.
Maybe put a legend on the contract so any buyer might see it.
UW status is deemed if purchased from an issuer with a view to distribution.
Integration
Single plan of financingtrying to finance one item with both sales
Same class of securityone class of stock makes them all fungible. But if PP
and S-1 sale are of different classes, they cant be exchangednot integrated.
Easier to make non-fungible debt than non-fungible securities
Debt, just make different interest rates and different terms.
At or about the same time
Same type of consideration received
Offerings made for same general purpose
ABA Position Paper found decisions to rest on 5 factors (based on Purina and 4552)
Sophistication
Limitation on offerees needs to be based on some level of sophistication
Can give the class of offerees a representative to make them sophisticated
Informationmake people sophisticated by educating them in the company through
disclosure
Manner
Cant condition the market to make non-sophisticated people want them by
sending out a mass advertisement saying only available to sophisticated buyers
Creates exemption for all sellers that arent issuers, underwriters, or dealers.
Main emphasis is on underwriters because dealers/brokers have their own exemption.
UWpurchases from the issuer with a view to distribution.
For purposes of who is an UW, issuer broadly defined to include control persons
Includes CEO, subsidiary, parent company, director, etc.
10% equity interest is a rule of thumb to make SH a control SH and affiliate of corp.
Control groupindividual is deemed to be a control person/affiliate if he is member of
group that has control (family, board of directors, firm with controlling share).
What is distribution?
Courts and SEC have defined distribution as a public offering.
Many things are public offerings but dont count
Two Types of Transactions we are concerned about
Control SecuritiesIssuer sells part of its shares to the public and some shares to officers
and subsidiaries to hold onto in a registered offering. Then a few years later, without
registering, it has its officers and subsidiaries sell to the public when it would not be able to.
Upon redistribution, the seller is an issuer and the buyer is an underwriter.
Ira Hauptbroker sells for account of controlling SH of a company. SH is an issuer as a
control person under 2(a)(11). Makes broker an underwriter b/c selling for an issuer in
connection with a distribution.
Restricted SecuritiesIssuer makes Private Placement to buyer, buyer sells it to the public.
Shares never come to rest, so PP buyer is an underwriter
Sherwoodbuyer buys stocks in a PP with intent to hold on indefinitely. Circumstances
change and he has to sell the securities2 year holding period considered acceptable
before Rule 144.
Change of Circumstances doctrine now defunct. Release 4552.
Public Resales
Rule 144 is a safe harbor for how to publicly resell these securities safely
Definitions
Affiliate = Control person
Restricted Securitiesfrom issuer/affiliate not involving public offering: Reg D, 144A,
CE, Reg S, 4(a)(5), 4(a)(2)
Safe Harbor creates four categories of transactions
Unrestricted Securities, Non-affiliatesno restriction
Restricted Securities, Non-affiliatemust meet (c)(1) and (d) if reporting
144(c)(1)current public information by reporting issuer. Issuer has been s/t
reporting requirements for 90 days before the sale.
144(d)Holding period
Reporting Company6 month
If held for a year, then no info requirement necessary.
Non-reporting Company1 year.
Non-reporting companies only have to meet (d)
Restricted Securities, Affiliatemust meet all requirements
(c) requires current public information for both reporting and non-reporting
(d) holding period
(e) limits the amount of the salenot more than 1% of outstanding shares in 3
month period.
(f) manner of salemust be anonymous broker transaction
(h) notice of salemust notify commission if >$50,000 or 5000 shares.
Unrestricted Securities, Affiliatedo not have to meet holding period requirement
Economic Reality Test: If buyer doesnt take on real risk of the stock (e.g. Issuer pledges to
indemnify buyer in case of any losses on resale), then this is really a public offering by the
issuer
If outside of Rule 144, you can argue you dont meet control person or that you held it for 2 years.
Private Resales4(a)(1.5)
Private Placements by their terms only apply to issuers, so cant be used on resale.
However, if you avoid underwriter status by avoiding a distribution (i.e. doing a private
placement rather than public offering)then you meet 4(a)(1)
Rule 506 doesnt completely apply, but you could do an equivalent transaction without
advertising it to the public.
Private resale safe harbor is Rule 144A
Allows resales to Qualified Institutional Buyers (QIBs) after an exempt placement.
QIB
Corp. that owns or invests more than $100MM in securities of non-affiliates
Banks and savings & loans
Registered dealers ith more than $10MM investments in non-affiliates
Sales by dealers are covered in (c) and are generally ok.
Sales by person who is not issuer or dealer are not deemed an UW if:
Offers are only to QIBs
What you can rely on
Most recent publicly available financial statement (of last 16 months)
Info in forms filed with SEC
Public info in Securities Manual
Certification by CFO or other executive stating amount of discretionary
investment company has.
Take reasonable steps to inform of restricted status of 144A exemption.
Not fungible
Non-fungibility requirementsecurities cant be listed nationally at time of
issuance because it cant be fungible with publicly traded securities.
Necessitates debt securities.
Reasonably current information on issuer upon request by purchaser.
144A(e) provides integration safe harborif someone sells to public, it doesnt destroy
the entire chain of transactions
How all of these alternatives work on private resale market
506 is what is most commonly used, but problem is if one person sells to the public, the
entire transaction loses its exempt status. One big integrated transaction.
144A would take care of the integration problem, but then it is limited to QIBs
144 may work if issuer sells to employees and they wait a year and start a market. No
restrictions then, but the problem is if the original seller is affiliated.
Strict Liability for material misstatements and omissions on registration statement at time
it becomes effective.
No liability under Sec. 11 for preliminary prospectus.
Materiality defined by Rule 405
Not liable for systemic world events (War with Syria tomorrow!)
In re Adams Golf (2004) involved golf club company failing to disclose
graymarket had been started for its clubs which would decline future revenue.
Announcement in press release didnt cause price to drop of stock.
Helps prove immaterial under EMCH, but there could be other reasons.
Proving that info is immaterial saves you from liability.
Escot v. Barchris discusses materiality through the various lies told by Barchris
Earning Statementsdiscounted cash flow to show actual earnings and the value of
the difference. Percentage differential.
Backlogorders that cannot yet be filled. Lying would show increased coming
cash flow in the future.
Failure to disclose officers loans outstanding and unpaidconflict of interest
Failure to disclose use of proceedsreally paying bonuses instead of investing.
Defendant must show non-causation under 11(e), whereas in 10b-5 plaintiff must make
out causation.
Publicly available information does not normally have to be disclosed.
May have to disclose special risk to your business if something that is public
knowledge happens
Sufficient to say that the risk is dependent upon the price.
Bespeaks Caution Doctrinea court may determine that inclusion of sufficient
cautionary language in a prospectus renders misrepresentaions and omissions contained
therein non-actionable. In re Donald Trump Casino.
meaningful cautionary statements make forward-looking statements not create
basis for fraud claim if dont affect total mix of info provided to investors.
Cautionary statement must be specific, so you cant just include every risk .
Including too many makes it all meaningless. Vonage.
R. 175 and 1995 reform make forward looking statements more protected.
Due Diligence Defense
Issuer has no defense for misstatements.
Expert
Expertized Portion of the RS
Reasonable investigation that provides reasonable ground to believe the
statements were true
Ex. Audited financials, engineering reports, oil reserves
Non-Expertized Portion
Reasonable investigation that provides reasonable ground to believe it is true
Non-Expert
Expertized Portion of RS
Show you had no reasonable ground to believe it wasuntrue
Non-Expertized Portion of RS
Reasonable investigation that provides reasonable grounds to believe it is true.
Reasonable investigation is a sliding standard based on your involvement. Managers and
underwriters are very involved. They can delegate this task.
Only those who purchased in IPO or directly from issuer can sue under Sec. 11, not those
who purchased in the trading market.
Damages are in 11(e)Difference between amount paid for security (not to exceed IPO
price) and a number of variable things.
10b-5 requires fraud, but gives higher damages.
Choose both.
Illegal offers and Sales12(a)(1)
If you mess up the registration statement process, this is where your liability comes from.
Strict liability for not following the correct procedure.
Recission liabilitybuyer from illegal offer/sale can get their money back.
Basically a put option for the buying price.
2 types of options
Putright to sell at a certain price
If trading at lower than the put, you can make money by buying a stock
then selling it at the put price.
CallRight to buy at a certain price
If trading at a higher price, you can make money by buying at the call
price then reselling at market price.
Requires direct link between issuer and purchaser.
Cannot fix a 5 violation after the fact. Once violation happens, liability sticks. Diskin.
Who is the Seller?
Broad conception of who is a seller.
Dahlinvestor in oil wells (who doesnt own any of these oil wells) recruits friends to
come buy interests from Pinter.
Dahl (investor) is an expert, so he is carrying out the diligence for all of his friends
and says there are productive wells.
Wells end up not producing after Pinter sells to Dahls friends and friends suePinter
Pinter sues for contributionwins.
Nothing in definition of sell requires passing of title. Offers include
solicitation.
Seller must somehow benefit himself through the sale, but doesnt have to be
the former owner of the securities. Cant only be interested in benefit of buyer.
No commission is not a conclusive non-interest. Can be liable if advancing your
own or owners interest. Rejected Substantial Factor Test.
Seller Liability for Prospectus12(a)(2)
This provision has been somewhat gutted by Gustafson, which says this only provides
liability to original issuer and not subsequent sellers with individual prospectus misstatement.
Gustafson says that prospectus is only document of wide dissemination, so offer letter to
an individual doesnt count.
THIS IS WRONG. But we are stuck with it.
Makes it so 10b-5 is way more common.
Allows previous sellers to sue up the ladder. Purchaser 5 cant sue issuer because no privity.
However, he can sue purchaser 4 who can sue purchaser 3, etc.
If purchaser 3 made the material misstatement, liability stops there.
Coverage is broader than 11final prospectus, FWP, preliminary, oral communication, etc.
Also covers exempted communications and info from people who are not the issuer or
affiliates.
Same standard of care as 11Sanders says reasonableness requirement is same as
reasonable investigation.
Aiding and Abetting15
Provides liability for control persons if they did not have reasonable belief that statements
were not true.
Test
Relationship giving access
Inherent unfairness of unequal playing field.
Texas Gulf Sulpher involves geologists who know that they had a big find.
Bought a lot of securities when company made misleading statement that it didnt
have a big find because they knew that it did.
Duty to disclose or abstain from trading when information is likely to have
effect on price.
Duty applies to anyone in possession of material inside info
Economics of Insider Trading insider trading will depress market prices and keep outsiders
out of the market because it is a lose-lose for them.
Misappropriationget information from some relationship as vendor to the company
(financial printer or lawyer) and use it to insider trade.
ChiarellaFinancial printer cracks code on documents and trades on it
Court said this wasnt an insider, so it didnt count
However, now that is against the rules.
U.S. v. OHaganlawyer insider traded, but not an insider because he wasnt the lawyer
on the case. Saw it on a partners desk.
Misappropriation theory adopted.
OHagan had duty to law firm to not misappropriate information
When he misuses info he breaks his duty to law firm in connection with
sale/purchase of security.
U.S. v. CarpenterWSJ writer misuses power of article changing prices to trade before
publication. Same thing.
In Connection With Requirement
Materiality will satisfy in connection with as long as there is public dissemination
Semerenko expressly relies on the ECMH to say that if price moves we have materiality and
in connection with
If there is a price change in the market, someone is buying or selling based on a different
price than they would if information was correct.
Market integrity and broker integrity are suitable grounds for 10b-5 suit. Zandford.
Breach of fiduciary duty in trying to screw SH does not necessarily come under 10b-5,
especially if there is another law covering that specifically. Santa Fe (short-form merger
situation with false valuation).
Reliance and Causation
Reliance requirement doesnt come from statute, but common law fraud requirement.
Affiliated Ute Citizenin face to face transactions, if there is material misleading
information then there is no proof of reliance required.
Defendant can rebut the presumption of reliance
Has been extended beyond face-face transactions including fiduciary duty claims
Duty to disclose only applies to insiders sale, not all other peoples losses who are trading.
Too speculative to say other people wouldnt have traded if insider abstained or
disclosed.
Damages are limited to people he actually sold to or purchased from.
Basic v. Levinson adopted ECMH and Fraud on the Market Theory
FOTMTEven if purchaser didnt rely on actual statement made, but relied on public
price, reliance and causation are satisfied.
Rebut the presumption by showing P knew a statement was false or by saying statement
didnt change the price because no one believed it.
10b-5 Elements
Fraud
Scienter
Inferences are allowed. Motive is taken into account by courts (show incentive)
Recklessness generally counts
Corporate Knowledge
Agent making statement for company must know statement is false or be
recklessly negligent in not finding out it is true for liability to be imputed on
company
Minority says if one agent knew of falseness that suffices
Materialitywhat a reasonable investor deems important
Deductionuse net present value to find out what information is worth.
Inductionlook at how the market responds. ECMH
Reliance
Fraud on the Market Theory
Rebuttable
Becomes corollary of materiality
Who relies on fraudulent price?
People who purchase between fraudulent announcement and revelation of
fraud
Dura says P must show economic loss so that price inflation isnt enough, but
you need a drop (seems wrong because you paid too much if price is inflated)
Causation
Transaction causationfraud induced transaction
Loss causationfraud caused the actual loss complained of
Damages
Bastian is bad decision by Posner which makes it so lying is profitable.
no harm, no foul
However, expected value of lie makes it so they can lie and if it is just a bad market,
they win.
By any person
In connection withdiscussed above
The purchase or sale
Blue Chipmust actually purchase stock. Cant say you would have if the information
wasnt falsely negative.
Wharfgetting securities in return for services is still purchase
Of any security